Money and Banking Chapter 15

Learning Objectives

-Illustrate the market for reserves, and demonstrate how changes in monetary policy can affect the equilibrium federal funds rate. -Summarize how conventional monetary policy tools are implemented and the relative advantages and limitations of each tool. -Explain the key monetary policy tools that are used when conventional policy is no longer effective. -Identify the distinctions and similarities between the monetary policy tools of the Federal Reserve and those of the European Central Bank.

Longer-Term Refinancing Operations

A category of open market operations conducted by the European Central Bank; similar to the Fed's outright purchases or sales of securities.

Forward Guidance

A central bank commitment to a future path of the policy interest rate.

Lender of Last Resort

A lender that provides reserves to financial institutions when no one else is willing to do so; such lending is usually done to prevent a financial crisis.

Standing Lending Facility

A lending facility in which healthy banks are allowed to borrow all they want from a central bank.

Zero-Lower-Bound Problem

A situation in which the central bank is unable to lower short-term interest rates further because they have hit a floor of zero.

Summary 1

A supply and demand analysis of the market for reserves yields the following results: When the Fed makes an open market purchase or lowers reserve requirements, the federal funds rate drops. When the Fed makes an open market sale or raise reserve requirements, the federal funds rate rises. Changes in the discount rate and the interest rate paid on reserves may also affect the federal funds rate.

Management of Expectations

A term coined by Michael Woodford that refers to a commitment by the Fed to keep the federal funds rate at zero for an extended period in order to generate a fall in the long-term interest rate.

Credit easing

Altering the composition of the Fed's balance sheet in order to improve the functioning of particular segments of the credit markets

Repurchase Agreement (Repo)

An agreement whereby the Fed or another party purchases securities with the understanding that the seller will repurchase them in a short period of time, usually less than a week.

Matched Sale-Purchase Transaction (Reverse Repo)

An arrangement whereby the Fed sells securities and the buyer agrees to sell them back to the Fed in the near future.

Quantitative Easing

An expansion of the Federal Reserve's balance sheet.

Summary 3

Conventional monetary policy tools are no longer effective when the zero-lower-bound problem occurs, in which the central bank is unable to lower short-term interest rates because they have hit a floor of zero. In this situation, central banks use nonconventional monetary policy tools, which involve liquidity provision, asset purchases, and commitment to future policy actions. Liquidity provision and asset purchases lead to an expansion of the central bank balance sheet, which is referred to as quantitive easing. Expansion of the central bank balance sheet by itself is unlikely to have a large impact on the economy, but changing the composition of the balance sheet, which is accomplished by liquidity provisions and asset purchases and is referred to as credit easing, can have a large impact by improving the functioning of credit markets.

Summary 2

Conventional monetary policy tools include open market operations, discount policy, reserve requirements, and interest on reserves. Open market operations are the primary tool used by the Fed to implement monetary policy in normal times because they occur at the initiative of the Fed, are flexible, are easily reversed, and can be implemented quickly. Discount policy has the advantage of enabling the Fed to perform its role of lender of last resort, while raising interest rates on reserves to increase the federal funds rate eliminates the need to conduct massive open market operations to reduce reserves when banks have accumulated large amounts of excess reserves.

Primary Dealers

Government securities dealers, operating out of private firms or commercial banks, with whom the Fed's open market desk trades.

Defensive Open Market Operations

Open market operations intended to offset movements in other factors that affect the monetary base (such as changes in Treasury deposits with the Fed or changes in float).

Dynamic Open Market Operations

Open market operations that are intended to change the level of reserves and the monetary base.

Reverse Transactions

Purchases or sales of eligible assets by the European Central Bank under repurchase agreements or credit operations, with eligible assets as collateral, that are reversed within two weeks.

Deposit Facility

The European Central Bank's standing facility, in which banks are paid a fixed interest rate 100 basis points below the target financing rate.

Marginal Lending Facility

The European Central Bank's standing lending facility, in which banks can borrow (against eligible collateral) overnight loans from the national central bank at a rate that is 100 basis points above the target financing rate.

Target Financing Rate

The European Central Bank's target for the overnight cash rate, the interest rate for very-short-term interbank loans in the euro area.

Discount Window

The Federal Reserve facility at which discount loans are made to banks.

Conventional Monetary Policy Tools

The classic tools of monetary policy that the Federal Reserve uses to control the money supply and interest rates: open market operations, discount lending, and reserve requirements.

Marginal Lending Rate

The interest rate charged by the European Central Bank for borrowing at its marginal lending facility.

Overnight Cash Rate

The interest rate for very-short-term interbank loans in the euro area.

Federal Funds Rate

The interest rate on overnight loans of deposits at the Federal Reserve.

Summary 4

The monetary policy tools used by the European Central Bank are similar to those used by the Federal Reserve System and involve open market operations, lending to banks, and reserve requirements. Main financing operations-open market operations in repos that are typically reversed within two weeks-are the primary tool used to set the overnight cash rate at the target financing rate. The European Central Bank also operates standing lending facilities, which ensure that the overnight cash rate remains within 100 basis points of the target financing rate.

Nonconventional Monetary Policy Tools

The non-interest-rate tools used by central banks to stimulate the economy: liquidity provision, asset purchases, and commitments to future monetary policy actions.

Main Refinancing Operations

Weekly reverse transactions (purchases or sales of eligible assets through repurchase agreements or credit operations, with eligible assets as collateral) that are reversed within two weeks and are the primary monetary policy tool of the European Central Bank.